In early January, we put out our outlook for 2014 (see our piece “Of Elephants and Rates”). So far, things are turning out about as we expected. Looking at a few of our specific takes:
Interest Rates: We had expected that rates would not see a significant upward move and may well even see a decline due to various issues, including the economy and demographics. After all of the fear of higher rates and the vast majority seeming to be in the higher rate camp for 2014, so far we have actually seen rates fall from about 3.0% on the 10-Year Treasury at year-end to about 2.65% today. And the rising rate rhetoric has certain moderated.
Increased Demand for Fixed Income Securities: Related to our interest rate take was our expectation that the notion of a “great rotation” from fixed income into equities would not materialize; demand for fixed income would be driven by demographics, further constraining rates. While this this a long term issue, and will take time to play out, we have definitely seen recent indications that flows into equities are reversing. We recently saw the largest weekly outflow on record in U.S. equities of -$18.8 billion1 and on the flip side we have seen positive data points in the fixed income space, with, for example, money pouring into fixed income exchange traded funds (ETFs), with February on pace for a record inflow.
Trendless Equity Market: We had expected that equities would face a number of headwinds in 2014, including the already high valuations and the lack of significant growth drivers. After a weak start to the year in equities for January, in recent weeks we are starting to see some move up on the back of lower rates. So as we get through the first couple months of the year, equities are about flat. However, the calls for the equity market being overvalued (such as news the that legendary investor George Soros increased his bet against the S&P 500) and caution at current levels seem to be getting more attention.
Higher Energy Prices: While the spin has been the U.S. “energy independence” and “shale revolution” will put pressure on oil prices, we have stated that we believe this shale production outlook is largely overstated. Current shale production levels will be short lived, and it will be more costly to produce as we go forward, meaning oil prices will need to stay high to compensate producers. So far this year we have seen a move up in oil prices and a significant spike in natural gas. And this has happened despite some of the recent global economic weakness.
As we look forward, we continue to see plenty to be cautious about. The economic data appears to us to be rolling over here in the U.S., with a weak jobs report and a sharp plunge in ISM manufacturing data, among others. The drought in the West is impacting major agricultural areas, causing higher food prices. The spike in energy is translating to higher costs to fill up your car and heat your homes, which along with the food prices is a direct hit on the discretionary income of consumers…and two-thirds of GDP is tied to the consumer. We’ve seen several data points out of China over the last couple months indicating that country is slowing. Emerging markets have had well publicized issues, be it social and political turmoil in Ukraine and Venezuela or currency issues in Turkey and Argentina. Global growth has also been weaker than expected. Municipal bonds have faced recent challenges, with Puerto Rico’s viability in question and then continued issues with the Detroit bankruptcy.
Investors should be cautious on how they allocate their money. As we stated in our year-end piece, true active management in all asset classes will be required in the year ahead. It is clear to us that some companies will thrive and some will not in this environment and investors need to do the fundamental work to discern which category their investments fall into; we believe the days of a widespread move up is behind us. Those betting on further expansion in equity valuations from current levels may well be disappointed as there appears to be little in the way of actual growth globally. As we have stated before, one benefit of investing in bonds versus equities is that as bond investors, we just need to make sure the company can pay their bills, including our interest, and has the ability to pay back or refinance the debt before maturity. Bond investors have a set coupon rate on the bonds, which provides them tangible income, and a set maturity date to get their money back. We generate our yield from the coupon income and don’t have to bet on valuation expansion or earnings growth to achieve our ultimate return.
As we look into 2014, we expect that certain high yield bonds and floating rate loans will continue to be positioned well in this environment and generate what we view as attractive returns for investors, but active management will be key.